Schroders Capital: Getting to grips with carbon risk

This article is sponsored by Schroders Capital

The race to net zero was never going to be a smooth linear progression. Slashing emissions, improving the energy efficiency of buildings and decarbonizing construction materials requires transformational change and all this at a time of broiling geopolitical and economic turmoil. 

On the positive side, investor demand for transparent sustainability metrics are slowly moving the industry in the right direction. This transparency is crucial if real estate is to rally jointly around the critical actions needed to avoid global temperatures rising more than 1.5C. Charlotte Jacques, head of real estate sustainability and impact investment at Schroders Capital, considers these themes and the intersection between the climate and social pillars.  

Is the real estate industry doing enough to decarbonize? 

The industry has an enormous amount to do with real estate responsible for circa 40 percent of global energy consumption and carbon emissions. The Paris Agreement has been translated to sector goals to reduce “operational” emissions to zero by 2030 and all carbon emissions by 2050. But it seems we are not yet collectively meeting these targets, shown by discussions at COP27. 

There are many stakeholders to engage. In Europe, the ownership structure is fragmented and institutional and private investors have very different motivations.

Landlords are responsible for Scope 1 and 2 emissions, but the industry needs to consider Scope 3, essentially tenant emissions. These are harder to abate and represent the larger proportion of building emissions. A building can be BREEAM outstanding, but operationally nothing is achieved if systems don’t measure and manage daily usage (and tenants heat the buildings while leaving a window open). Tenants of course also have a Scope 3 challenge and also need data to manage.  

Therefore, we need collaboration by all market participants, whether a facilities manager, architect, concrete manufacturer, investment manager or tenant. We all need to stand up and recognize what our activities are doing from a carbon perspective, and together effect change at every product and service level. 

How is the macroeconomic backdrop affecting this dynamic? 

One of the opportunities of the current energy situation is that reducing energy consumption is now being prioritized, which has a direct benefit to carbon emissions. But organizations are nervous about whether they can afford to make additional sustainability investments in today’s economic situation. There is protectionism with a focus on short-term stability and returns. 

This is the frustrating disconnect. We have pension funds investing to deliver good quality pensions and focused on yearly performance. But if sustainability measures are not considered, longer term investment performance might be significantly harmed through building obsolescence, or worse – damage from climate change itself.

In short, if we are not looking long term, we will not have a good quality world to live in, whether in 10, 20, 30 years or beyond. A sustainability and impact active investment approach is proven to improve tenant attraction to assets, is a significant risk mitigant and can ultimately improve long-term performance.

How did you come to be involved in the ULI C Change project and what is its purpose? 

During the ULI taskforce we concluded sustainable development of new buildings is subject to strict regulation and moving in the right direction. However, the industry must not demolish older buildings and replace with new sustainable ones, given the additional (embodied) carbon emissions and circularity lost. Such a strategy does no justice to embodied carbon in existing assets. We concluded decarbonizing existing buildings is the largest task the industry should tackle together. 

We sponsored the Urban Land Institute C Change initiative to identify how to mobilize transformational change across the industry. Decarbonization is not a subject for market competition. The climate crisis is a juggernaut coming right at us; we cannot pass our energy and emissions’ responsibilities on to others.

A fundamental need is to help people be fluent on carbon. Many people think sustainability is too complicated and avoid engaging with it, but actually it is simple; we need to understand how a building operates day to day, what can be done to improve it considering both energy and cost efficiency, as well as comfort, and how to build resource and operationally efficient buildings.  

The investment market therefore needs to explicitly understand carbon risk and opportunities, actions and cost required to optimize building stock. These transition costs need to be factored into valuations to show the risk and reward of decarbonization. 

How does carbon transparency come into the picture with ULI C Change?

The industry has a massive data challenge; we need to understand how much energy a building is actually consuming to determine improvements. Sadly, we’re all spending too much time improving data quality, which impairs our ability to improve transparency.

The ULI C Change project is aimed at sharing this data, alongside a standard set of metrics for appraisals, to facilitate market transparency. We need to know likely costs of transforming a building to meet net zero and regulatory requirements and that it will deliver good occupational experience to occupiers under different climate scenarios. 

At Schroders, we have introduced a notional carbon tax into our underwriting to make carbon an explicit item. Inclusion helps education and supports our team’s carbon fluency into an everyday aspect of active investment management and ensure timely action and focus on the biggest contributors. 

The link between reporting energy and greenhouse emission numbers and the risk and financial impact to operations needs to be improved. This holds true both in the investment market and for our tenants. This will help develop operational practices to reduce risk and cost impacts and build resilient businesses.

Is greater transparency something you find investors asking for?

We are receiving an increasing number of requests from clients and numerous industry and regulatory reporting frameworks. For example, the UK’s FCA has made the Taskforce on Climate-related Financial Disclosures mandatory, as has the UK pensions regulator. Of course, we have Sustainable Financial Disclosure Regulations and other jurisdictions’ equivalents. Our investors are also coming to us with specific requirements because they want to hit compliance requirements, but also their own net-zero targets. 

We now have too many frameworks and requests and sustainability is in danger of becoming a compliance exercise. We believe the industry should work together on a collective framework so we can achieve transparency but also immediate focus of resources on action rather than reporting only. 

Thinking about social aspects, how do these need to be integrated alongside energy and carbon? 

From a responsible business perspective, we need to consider both our environmental and social impacts and ensure we address not only the carbon priority but that we balance this with quality of spaces and places we are custodians of. Spaces need to be comfortable and inspiring for us all to thrive.

Particularly through the pandemic, there has been an emphasis on safe spaces for people to live and work, whether touch-free access or confidence ventilation is suitable. You also need to think about the quality of suppliers: are they local; what is the level of pay; is there employee training and apprenticeships; and how is the risk of modern slavery reduced?

Ultimately, we need to tackle the net-zero mission responsibly across our value chain to deliver good buildings which are comfortable for people and resource efficient for the planet. We can also put social impact as a driver to investment strategy.

What more should the industry be doing for social impact? 

The industry has the opportunity to deliver positive social impact by virtue of our experience to deliver space and focusing it on those in need. With an impact investment you should be clear from the outset on your impact intention, what you are going to deliver and who will benefit. Then demonstrate your activity in fact made a social impact above and beyond what a normal investment would deliver.

The “theory of change” is key: what activities will bring what outcomes and therefore impact delivered. At Schroders we think about what problems can we help solve and what capital can we bring together to solve them.

A good example for real estate is delivering good quality, affordable homes and in a deprived area, you know the tenants are likely to be in social housing and will benefit from a more comfortable family home environment and more local amenities. This in turn will help mental wellbeing and making residents feel more confident finding employment. 

The multiplier effect here can be significant. The direct social impact is quantified by the number of homes provided, in what areas of need and at what levels of affordability. The indirect impact includes the spend and jobs in the local area refurbishing or developing the homes. 

We have the opportunity to mobilize institutional capital into a wide range of investments with a social purpose, not only homes, but also better healthcare facilities, modern and affordable workplaces, community retail, services, amenities and more. The essential components for supporting social change, fostering cohesive communities and addressing inequalities.

Of course, this should always include a positive environmental strategy and deliver a risk-adjusted financial return. Approaching the social aspects of ESG alongside the environmental ones is a powerful investment purpose that can deliver long-term investment performance at the same time.

How would standardizing reporting frameworks be helpful? 

There is a great need to drive the market to standard valuation frameworks, as put forward by ULI’s C Change program, which will help make risk and reward more transparent. ULI’s Transition Risk Assessment Consultation Guidelines and accompanying discussion paper, Breaking the value deadlock: enabling action on decarbonization, will help. 

We also have no agreement yet on what a net-zero building looks like. Therefore, how can we demonstrate a good outcome has been achieved to our occupiers and investors? The UK Net Zero Carbon Buildings Standard is a project focused on the building definition – an industry project involving the BBP, RIBA, UKGBC and others. Until we get a defined, agreed and accepted standard, it is difficult to compare buildings.